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Thursday, August 8, 2013

Scott Sumner latest paper titled a "Market-Driven Nominal GDP Target" came out last month at the Mercatus Center. It is the best piece I seen so far on nominal GDP futures targeting. It addresses all the critiques of his proposal and highlights different version of it. My understanding of nominal GDP targeting was sharpened after reading it.

Many, if not most, economists and pundits believe that higher capital requirements for banks would go a long way in establishing a more secure financial system. Joshua Hendrickson, however, raises some questions about this view and argues here, here, and here that removing the limited liability status of banks (i.e. creating contingent liabilities for shareholders) would better.

Update: Ryan Avent has a great piece on the unfinished revolution in central banking.

Tuesday, August 6, 2013

Back in June I proposed that helicopter drops become a normal, systematic part of countercyclical policy. Here is what I said:

First, the Fed adopts a NGDP level
target. Doing so would better anchor nominal spending and income
expectations and therefore minimize the chance of ever entering a
liquidity-trap. In other words, if the public believes the Fed will do
whatever it takes to maintain a stable growth path for NGDP, then they
would have no need to panic and hoard liquid assets in the first place
when an adverse economic shock hits.

Second, the Fed and Treasury sign an agreement that should a liquidity
trap emerge anyhow and knock NGDP off its targeted path, they would then
quickly work together to implement a helicopter drop. The Fed would
provide the funding and the Treasury Department would provide the
logistical support to deliver the funds to households. Once NGDP
returned to its targeted path the helicopter drop would end and the Fed
would implement policy using normal open market operations. If the
public understood this plan, it would further stabilize NGDP
expectations and make it unlikely a helicopter drop would ever be
needed.

This two-tier approach to NGDP level targeting should create a foolproof
way to avoid liquidity traps. It should also reduce asset boom-bust
cycles since NGDP targets avoid destablizingresponses to supply shocks that often fuel swings in asset prices.

Scott Sumner was not impressed and argued that helicopter drops have been tried for 20 years in Japan to no avail. Like Steve Randy Waldman, I belive not all helicopter drops are the same. What I envisioned is not what happened in Japan prior to Abenomics, but having the Fed (via the Treasury Department) directly deposit dollars into tax fillers' checking accounts in conjunction with a clearly communicated NGDP level target. That approach has not been tried and would directly address the excess money demand problem that is behind aggregate demand shortfalls.

Helicopter drops along these lines also need not imply large distortionary taxation in the future. The stable nominal income expectations that they would create and the relative ease of implementing this kind of helicopter drop would prevent the buildup of excess money demand in the first place. But even if the Fed did need to reverse itself in the future, one could always allow the Fed to start issuing it's own bills and notes. They could be funded by current and future seigniorage and would not be that different than its current practice of paying interest on excess reserves.

The real reason, however, Sumner should be for this proposal is that it provides insurance against central bank incompetence. Sumner loves to say that the fiscal multiplier is nothing more than an estimate of central bank incompetence. That is, the fiscal multiplier is large only when the central banks fail to properly stabilize aggregate demand. Well, helicopter drops are fiscal policy and in my proposal they would be applied only when the Fed failed to stabilize demand. Therefore, it is a perfect fit. Employ fiscal policy only when it packs a punch and do so in a manner to preserve a NGDP level target.

Yes, if central bank were to adopt a NGDP level target and faithfully execute its mission then none of this would be necessary. But if the past four years have taught us anything, it is that central banks can be very incompetent. And of all people, Scott Sumner has been the loudest in making this point. He, therefore, should excited about insurance against central bank incompetence. This is a modest proposal to that end.

In my previous post, I argued that for monetary policy to be effective in a liquidity-trap like slump, the increase in the monetary base has to be seen as permanent. That is, if the central bank signals and the public believes that a large enough portion of the expanded monetary base will be permanent even after a recovery takes holds, then investors will realize the monetary base and treasury will not be near substitutes in the future. Consequently, they will start rebalancing their portfolios today and that, in turn, will spur growth in aggregate demand.

What I did not spell out is how this would unfold if the Fed continues to pay interest on reserves (IOR). The same conclusion holds, but in addition to the Fed permanently maintaining some portion of its expanded balance sheet it would require the central bank not to raise the IOR as other market interest rates rose. Another way of saying this is that as the recovery pushed up the equilibrium or natural interest rate, a decision by the Fed to keep the IOR pegged at 0.25% will result in more inside creation, more spending, and ultimately higher inflation for a given stock of the monetary base. For a more thorough discussion of this point, along with some summary tables, see this earlier post of mine as well as this one by Steve Randy Waldman.